Chapter 7

Global Bond Investing

7-2

Introduction

• In this chapter we look at:– Bond market statistics– Major differences among bond markets– The Eurobond market– A recap of bond valuation– Multicurrency bond portfolio bond management– Exotic bonds (from FRNS to structured notes

found on the Eurobond market)

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World Market Size

• The world market capitalization is higher than that of equity.

• The relative share of each currency market depends not only on new issues and repaid bonds, but also on exchange rate movements.

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Exhibit 7.1 Market Capitalization of Domestic Bond Markets

7-5

The Global Bond Market

• Domestic bonds:

– Issued locally by a domestic borrower and are usually denominated in the local currency

– Usually make up the bulk of the national bond market

– Issuers include government, semi-government and corporate agencies

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The Global Bond Market

• Foreign bond market– Issued on a local market by a foreign borrower

and are usually denominated in the local currency.– Foreign bond issues and trading are under the

supervision of local market authorities.– Foreign bonds include:

• Yankee bonds (in the U.S)• Rembrandt bonds (in the Netherlands)• Samurai bonds (in Japan)• Matador bonds (in Spain)• Bulldog bonds (in the UK)

7-7

The Global Bond Market

• Eurobond market– Underwritten by a multinational syndicate of banks and

are placed mainly in countries other than the one in whose currency the bond is denominated.

– Also known as an “international bond”.– Eurobonds are not traded on a specific national market.– However, there are Eurobonds listed on the Luxembourg

Stock Exchange to nominally satisfy the requirement of obtaining a public quotation at least once a year or quarter.

– Developed in the 1960s and was early recognized as an efficient, low-cost and innovative market.

– Avoids most national regulations and constraints and provides sophisticated instruments.

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Exhibit 7.2 Market Capitalization of Eurobonds

7-9

The Eurobond Market — Characteristics• The underwriting syndicate is made up of

banks from numerous countries.• Underwriting banks tend to use subsidiaries

established in London or a foreign country with a favorable tax situation.

• Corporate borrowers use a subsidiary incorporated in a country with a favorable tax and regulatory treatment.

• For fixed-rate Eurobonds, the frequency of coupon payments is usually annual.

• Eurobonds are sold in a multistage process.

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Exhibit 7.3 Eurobond Tombstone

7-11

The Eurobond Market

• Issuance Process– Issuing syndicate:

• issue is organized by an international bank called a lead manager.

– Timetable of New Issue (total time: 5 to 6 weeks):

• discussion between lead manager and borrower (2 weeks or more).

• Announcement of Eurobond issue (1 to 2 weeks of preplacement).

• offering day with final terms (2 week public placement)• Closing day: selling group pays for bonds

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The Eurobond Market

• Issuance Process

– Dealing in Eurobonds:

• Eurobond dealers created an around-the-clock market among financial institutions across the world, forming the International Securities Market Association (ISMA).

– Eurobond Clearing Bond:

• A trade is settled in three business days and the transactions are cleared through either Euroclear or Clearstream (formerly Cedel).

• Euroclear and Clearstream collect a transaction fee for each book entry as well as a custody fee for holding the security.

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Brady Bonds

• A Brady plan is a debt-reduction program whereby sovereign debt is repackaged into tradable Brady bonds, generally with collateral.

• Close to 20 countries have issued Brady bonds and the total market capitalization is close to $100 billion.

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Brady Bonds (continued)

• Three main types of guarantees can be put in place:– principal collateral– rolling-interest guarantee– value recovery rights

• Two major types of Brady bonds have been issued:– par bonds– discount bonds

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Major Differences Among Bond Markets• Quotation

– Bonds are quoted in the form of a clean price net of accrued interest.

– The full price (or value) of a bond is the sum of its clean price plus accrued interest.

– Accrued interest = Coupon (days since last coupon date/days in coupon period).

• Coupon Frequency and Day Count

– The day count convention known as “30/360” is commonly used in Germany, Scandinavia, Switzerland and the Netherlands.

– The day count convention known as “actual/actual” assumes a 365 day year.

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Exhibit 7.5 Coupon Characteristics of Major Bond Markets

7-17

Major Differences Among Bond Markets

• Yield to Maturity:– The yield to maturity (YTM) is the average

promised yield over the life of the bond.– The convention used to calculate YTM varies

across markets.– In the U.S, YTM is calculated at a semiannual rate

and the result is multiplied by 2 to report an annualized rate.

– Most Europeans calculate an annual, actuarial YTM.

– The simple yield approach is also used in Japan.

7-18

Major Differences Among Bond Markets

• Legal and Fiscal Aspects:– Bearer form (e.g., Eurobonds)– Registered form (e.g., In the United States,

owners must be registered in the issuer’s books)

7-19

Bond Valuation

• Yield to maturity: Zero coupon bonds

– There exists an inverse relationship between market yield and bond price.

• Yield to maturity: Coupon Bonds

– The U.S. YTM is a mixture of an internal rate of return calculation to obtain the semiannual yield, and of a multiplication to transform it into an annualized yield.

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7-20

Duration and Interest Rate Sensitivity• Duration is a measure of interest risk for a

specific bond.

• Mathematically, duration, D, can be written as:

(P/P) = –D r

• For larger movements in yield, the convexity can be used.

• The bond return can be approximated as:

Return = Yield – D (yield)

7-21

Credit Spreads

• The yield reflects a credit spread, or quality spread, over the default-free yield.

• The credit spread captures three components:

– An expected loss component

– A credit-risk premium.

– A liquidity premium.

• The migration probability is the probability of moving from one credit rating to another.

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Multicurrency Approach• International interest rate differences are caused

by a variety of factors including:

– Differences in monetary and fiscal policies.

– Inflationary expectations.

• Implied forward exchange rates:

– The formula is:

– By comparing the yield curves in two currencies, we can derive the term structure of implied forward exchange rates and therefore, implied currency appreciation or depreciation.

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Return on Foreign Bond Investments• The return from investing in a foreign bond

has three components:

– During the investment period, the bondholder receives the foreign yield.

– A change in the foreign yield induces a percentage capital gain/loss on the price of the bond.

– A currency movement induces a currency gain or loss on the position.

Return = Foreign yield – D (foreign yield) + % currency movement

7-24

Risk on Foreign Bond Investments • The risk on a foreign bond investment

has two major sources:– Interest rate risk: the risk that foreign yields

will rise.– Currency risk: the risk that a foreign

currency will depreciate.

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Return and Risk on Foreign Bond Investments • The expected return on a foreign bond is

equal to the domestic cash rate plus a risk premium. The risk premium equals the sum of:

– The spread of the foreign bond yield over the domestic cash rate.

– The percentage capital gain/loss due to an expected foreign yield movement, and

– The expected percentage currency movement.

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Currency-Hedging Strategies

• Foreign investments can be hedged against currency risk by selling forward currency contracts for an amount equal to the capital invested.

• The decision to hedge depends on return and risk considerations. Hedging will turn out to improve return on a foreign bond if the percentage currency movement is less than the cash rate differential (domestic minus foreign); otherwise hedging will not be advantageous, ex-post.

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International Portfolio Strategies• International portfolio management includes

several steps:

– Benchmark selection

• for bonds, market cap weights are influenced by the relative national budget deficits.

– Bond market selection

• managers can cite:

– monetary and fiscal policy

– public spending

– balance of payments

– inflationary pressures

– cyclical and political factors

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International Portfolio Strategies• Sector selection/credit selection

– government, regional and municipal bonds

– Mortgage-backed and public loan backed bonds.

– Investment grade corporate bonds

– Inflation indexed bonds

– Emerging market bonds

• Duration/yield management

• Yield enhancement techniques

– For example, spreadsheet analysis

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Structured Notes

• A structured note is a bond (note) issued with some unusual clause, often an option-like clause.

• Issued by a name of good credit standing.

• Can be purchased as investment grade bonds by most institutional investors.

• Offer long-term options that are not publicly traded.

• Designed for specific investors wishing to take a bet on interest rates or currencies.

• The issuer will usually hedge the unusual risks of a structured note and end up with a plain vanilla bond at a low all-in cost.

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Floating Rate Notes (FRNs)

• FRNs are a major segment of the Eurobond market.

• FRNs represent a quarter of all Eurobonds, with issues in euros and dollars playing a dominant role.

• Major issuers are financial institutions.

• FRNs are generally indexed to LIBOR.

• The coupon on Eurobond FRNs is generally reset every semester or every quarter.

• FRNs have coupons that adjust to interest rates, so coupons react to interest rate movements rather than the bond price.

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Floating Rate Notes (FRNs)

• FRNs exhibit great price stability when compared with straight bonds.

• The motivation for an investor to buy FRNs is to avoid interest rate risk.

• Bull FRNs strongly benefit investors if interest rates drop.

• An example of a bull FRN is a reverse (inverse) floater, set at a fixed rate minus LIBOR.

• Bear FRNs benefit investors if interest rates rise.

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Exhibit 7.11 Characteristics of Bonds, Assuming a drop in Market Interest Rates

7-33

Dual Currency Bonds

• A dual currency bond is a bond issued with coupons in one currency and principal redemption in another.

• Issued in two currencies with very different yield levels. The valuation ensures the fair coupon rate on the dual-currency bond is set in between the two yield levels.

• These are attractive because one is able to borrow money in a preferred currency but at a lower cost than directly issuing bonds in that currency.

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Currency Option Bonds

• A currency option bond is one for which the coupons and/or the principal can be paid in two, or more currencies, as chosen by the bondholder.

• It benefits the investor who can always select the stronger currency.

• The interest rate set at issue is always lower than the yields paid on a single currency straight bond denominated in either currency.

• They offer long-term currency play with limited risk.